We’ve noted from time to time that one of the many reasons this downturn will prove to be exceptionally bad is not just that corporate defaults are likely to equal, if not exceed, past post-war peaks. Two new factors are at work that will hurt junk bond holders.
First, many of the recent leveraged buyout deals, and thus a considerable portion of junk bonds outstanding, were cov-lite. That means when a company starts to deteriorate, the creditors lack their customary ability to renegotiate the debt and require restrictions on operations. Many analysts believe that the result will be that those companies will enter bankruptcy in worse shape than they would have if the creditors had been riding herd on them. That in turn will lower the recovery amount.
Second, debtor in possession financing has dried up. DIP enables companies to continue to fund ongoing expenses while working through the Chapter 11 process. A lack of DIP financing means that companies that might have been saved via Chapter 11 will be forced into liquidation. That in many cases will again lead to lower recoveries (the assumption behind Chapter 11, after all, is that a lot of companies are worth more alive than dead).
From the Financial Times:
Average yields on US junk bonds have topped 20 per cent for the first time amid rising concerns about a protracted recession and a wave of corporate defaults.
The spike in yields could have a dramatic impact on economic activity, making new debt prohibitively expensive for companies with credit ratings below investment grade. Such junk-bond issuers account for 17 per cent of the S&P 500 and nearly half the corporate bond market, according to Standard & Poor’s…
The yield on the benchmark Merrill Lynch US High-Yield index hit 20.81 on Wednesday after climbing to 20.27 per cent on Tuesday. Before Tuesday, the previous high for the index was 18.66 per cent in January 1991. The risk premium, or spread over comparable Treasury securities, is close to double what it was in 1991, when Treasuries were yielding more than 8 per cent.
Risk premiums on bonds with ratings below investment grade have hit new highs repeatedly in recent months as the credit crunch has grown worse.
Some long-term bonds issued by General Motors, one of the biggest non-investment grade issuers, have been yielding more than 50 per cent.
The latest surge in rates reflected ongoing uncertainty over a bail-out of GM and other US carmakers.
Investors were also rattled by last week’s announcement by Hank Paulson, US Treasury secretary, that the government had decided against buying toxic assets as part of its $700bn troubled asset relief programme.
The rise in yields comes as debt markets are trying to cope with a flood of forced selling by hedge funds and other investors seeking cash to meet demands for redemptions. Banks are also selling assets as they reduce their risk profiles.
In Europe, the market has not seen a large syndicated bond offering from a junk rated issuer since the summer of 2007.
Equities are falling because companies are running out of working capital. The corporate markets are dysfunctional. Risk aversion by portfolio managers and investors has either eliminated demand or raised the cost of capital.
One way to increase demand in the corporate markets would be to exempt corporate interest payments from some level of taxation. The amount and duration would need to be structured, but providing an incentive for participants to renter and start buying again is key to any solution. Maybe demand can be stimulated on an after tax basis and money would begin to flow again.
CRE and commercial loans are getting ready to tank! In the rush to lend money, all real lending standards were dropped. William at Brutal Honesty says it well.
William is right. We have a on of McDonalds, Burger Kings, Taco Bells everywhere. How can they ever all survive??????
Nice, Skippy, except Russ Winter beat you to it by a month or two….
Given a lack of liquidity and a high degree of risk aversion it isn’t surprising at all to see these sort of prices. With high grade corporate bonds trading at 550 and up why shouldn’t junk be in the high teens or low 20’s given the economic environment.
Personally, I find it refreshing that investors seem to be pricing risk back into the market.
Looks like Russ’s investments got stuck in the tar pit too.
“One way to increase demand in the corporate markets would be to exempt corporate interest payments from some level of taxation”
Good thought, but as Mark Twain observed:
“I am not so worried about the return ON my money, rather the return O my money”
I think this sums up the horrors in the CB market today.